Nature of Venture Capital
Venture capital represents long to medium-term finance, primarily directed at high-growth potential companies for substantial capital growth over a period. Returns typically come from capital growth rather than long-term holding and dividends. The investor will usually seek to liquidate its investment within a number of years, commonly three to five. Due to its nature, venture capital entails high risk, consequently demanding a higher return relative to safer investments.
Company promoters usually possess significant business experience and might have executed similar endeavours previously. They might lack personal resources to commence business, leading banks to perceive lending to them as too risky.
Investments in private companies raise many issues similar to those in shareholders’ agreements and joint venture arrangements. Investors seek protection of their investment, usually without active participation in the company, perhaps limited to the appointment of a non-executive director. Their aim is to have a mechanism to realise their investment in due course.
Venture capital is supported by tax reliefs, which may undergo changes over time. The present Employment and Investment Scheme replaced the previous business expansion schemes, which were a legislative feature for over 30 years.
Commonly used in management buy-outs and acquisitions, venture capital plays a crucial role in restructuring and rescuing companies to acquire existing debtholders. It’s often invested in companies with high potential that may lack commercial testing or experienced companies considering a management buyout. Mature companies may attract venture capital for acquisition and development, garnering interest from institutional investors.
Venture capitalists will generally require a significant proportion of the equity of the company at the early phase. They will require extensive powers to monitor the investment through the provision of financial information and perhaps the appointment of a non-executive director. They may have the right to veto significant transactions, which may impact the investment.
Structure of Investment
Usually, a new company is formed to acquire an existing business. Investors subscribe to shares and/or loans. Different classes of shares, such as preference shares and ordinary shares, might be created. The capital equity holding structure mirrors the investment’s corporate financing structure.
The structure and terms of the joint venture depend on specific circumstances. Companies may not initially be capable of paying dividends or interest. Instead, there might be prospects for a medium-term return and ultimate return on capital. In some cases, the return may occur upon the ultimate sale of the company, refinancing, or a buyout.
Equity stake and management provisions become pivotal issues. Initially, venture capitalists might hold a substantial proportion of equitable share capital, which could diminish over time. Changes in equity ownership may be outlined, gradually transferring the investor’s equity to the management to align their joint interests.
Venture capital funds specialise in investing venture capital on behalf of investors, meticulously examining each investment, with thorough financial and expert scrutiny of the company management and business proposal.
Venture capital sources vary, including private individuals incentivised by schemes like the Employment and Investment Incentive. Financial advisors, accounting firms, and intermediaries also connect clients with investment prospects.
Institutional investors, such as insurance companies, unit trusts, pensions, and banks, invest in private companies. They might act as intermediaries holding multiple investors’ funds.
Venture capital investments are specialist, risky, and time-consuming. While most investment vehicles are passive, some allocate part of their fund to venture capitalists, taking high portfolio risks for potentially higher returns. The intention is that the successful investments compensate for the unsuccessful ones.
The professional investor may provide considerable assistance for the management of the business in view of its wide experience and access to investors and funds. It may assist further financing and development assistance with key development, such as the appointment of a competent financial director.
Merchant banks may establish venture capital funds managed on behalf of institutional and private firms or invest their own claims. Many investments are organised through syndicates where multiple subscribers contribute funds, especially tax-based investments. Government entities, including enterprise boards, may provide some limited venture capital to high-potential startup companies.
Venture capitalists may seek to realise their investments through buyouts or refinancing. Alternatively, they might take the company public, offering liquidity in shares. Flotation usually involves issuing substantial further capital to the public.
The 1990 Act reforms enabled companies to repurchase shares, a method of realization through the accumulation of reserves and distributable profits.
Selling private companies typically requires extensive warranties from the seller. Venture capitalists, usually not involved in management, are usually reluctant to provide extensive warranties and indemnities regarding the company’s status. This limitation might affect the company’s sale and the ability to realise its value.
Venture capitalists will usually require significant warranties and indemnities from the existing management or entity. However, there may be limited financial capacity on the part of management to back up the warranties concerned.
A business that seeks venture capital will require a credible business plan. It may need advice from accountants and other corporate financial advisors in relation to structuring its management financial controls and business arrangements so as to meet the expectations of institutional and most other investors. Professional assistance may be sought in the preparation of the business plan.
Ultimately, the promoter may be requested to warrant the accuracy of the business plan, including financial projections. The warranties may be required to state that due care has been taken in preparing them and that they are intrinsically reasonable.
The business plan may be circulated among the prospective investors. Care must be taken to ensure that it is not a prospectus or does not otherwise trigger compliance with investment services legislation. It must not contain an invitation to subscribe for shares in itself and must be indicative in nature.
The business plan should show that there is a viable business capable of making a return on the investment. It must describe and convince investors of the strength of the business and management, which is set out budgets and the basis risk factors. It should provide details of the required finance and the ultimate exit mechanism.
Any investor is likely to undertake some degree of due diligence on the company. This will cover its financial compliance, financial position, assets management, legal arrangements, as well as the commercial merit of the business proposition.
It is likely to include investigation of the directors’ personal integrity, qualifications, bankruptcy, and convictions, examination of customer contracts, integrity in financial strength of customers, references for the company from customers, references for directors, financial report by an accountant, proposed budget, tests of the robustness and realistic budget assumptions, enquiries of banks and existing advisors’ due diligence on property, due diligence on the environment, and review of litigation risks.
In some cases, the investment may be undertaken by a single investor. Some individuals, particularly very high net worth individuals, may have their own investment vehicle. In other cases, the single investor may be a collective investment entity such as a fund management entity, a bank, insurance company, financial advisor, or other venture capital entity.
More commonly, a syndicate of investors is involved. It spreads the risk and may provide a greater range of services and advice. Syndication allows for a principal investor, a lead investor, and a number of passive investors who do not take the same active role in the investment.
Syndication may become unwieldy unless there are proper governance arrangements within the investor group. Commonly, the lead investors are appointed who undertake the relevant due diligence and are centrally involved. The promoters of the company will wish, apart from considerations of practicality, to deal with a single entity, and the passive investors should recognise the lead investor as being the best position to act on their behalf. The decision-making and coordination mechanism between the investors must be workable.
In the case of a syndicated investment, the legal relationship of the investors is defined by the Articles of Association and shareholders’ agreement. They do not create a separate vehicle in which to invest. Each investor becomes the owner of a part of the share capital, and typically any investor’s rights are exercisable by a majority of the value of the shares held by the investors.
In other cases, the company may deal with a single registered shareholder and deal with the lead investors only. The lead investor may hold its shares on trust for other investors. This may be appropriate for unitised fund investment.
Sometimes, investors cooperate formally or informally to create a syndicated structure and establish a lead investor as between themselves with powers to act on their behalf. They may agree on a syndicate pre-emption and profit-sharing arrangements, and the syndicate agreement will define their relationship. It may be contractual based on trust.
In some cases, the lead investor deals with the investee company at the outset and may have assembled the investors. In these cases, shareholders’ agreement may provide specifically to authorise the investor to syndicate his investment, perhaps subject to the approval of the parties concerned by the promoter company. There may be a list of prospective investors.
There are a number of professionally managed venture capital entities and syndicates. Taxation legislation incentivises and allows for the creation of funds, which may temporarily hold monies from investors pending investment in a qualifying company.
These commonly comprise accountants, financial institutions, stand-alone professional investors. In some cases, they may specialise in investing in a particular industry or sector. They may manage particular funds, which invest in particular industries and sectors. They may have discretion as to investment with their own investors or syndicate members.
In some cases, the syndicate is managed by one of the investors. In others, the management is entirely independent but may have options to invest to take shares in the company in order to incentivise the managers.
In some cases, the investors are limited partnerships. The general partner, which is itself usually a company, may be the manager of the fund. The other investors are limited partners.
Most funds are closed, and the investors may not redeem their subscribed capital on an ongoing basis. A venture capital fund allows the entrepreneur to deal with professionals who are experienced and can best assess the business practically after completing the investment, and who have aligned incentives.
An investor may buy into an existing investment, replacing the existing investor who may wish to exit and realise its investment. The exiting shareholder, by selling part of its interest, may change from being a majority shareholder to a minority. It may require protections within the context of changed bounds of power.
A dissenting shareholder may be purchased out. This may require amendments of the original investment agreement/shareholders’ agreement. It may require reorganization of capital. In some cases, warranties and indemnities may be appropriate and forthcoming.